Royal Dutch Shell plc: Slowly But Surely Improving

Despite a 44% year-over-year decline in quarterly profit, Royal Dutch Shell looks to be on a slow yet steady path to improvement.

Last week, Royal Dutch Shell plc(NYSE:RDS-A), Europe's largest oil company by market capitalization, reported a 44% year-over-year decline in its first-quarter profit. Yet better than expected performance from some of Shell's business segments was greeted favorably by the markets, sending the company's shares higher by a few percentage points on the day.

While Shell still has a long way to go in improving its financial performance and boosting returns on capital, the company's first-quarter results offered three encouraging signs. Let's take a closer look.

Photo Credit: Wikimedia Commons.

Progress in the downstream division The first encouraging development was a meaningful improvement in Shell's downstream segment, which posted adjusted refining profit of $1.1 billion, even though refining margins weakened across all company operating regions except for the U.S. Gulf Coast. Reflecting the company's outlook for continued pressure on downstream margins, it wrote off $2.3 billion in refining assets, most of it related to its Bukom facility in Singapore.

As part of its new strategy, Shell is restructuring its downstream business by divesting its least profitable refining assets. During the first quarter, the company agreed to sell its downstream business in Australia (excluding aviation), including the Geelong refinery and its network of some 870 retail gasoline stations, to commodities trading house Vitol for $2.6 billion. It also reached an agreement to sell certain downstream assets in Italy.

Shell now plans to divest its downstream refining and marketing businesses in Norway, Denmark, and the Czech Republic. That should enable the company to gradually improve the division's return on capital, which averaged 7% over the past 12 months. Shell believes that its downstream division has the potential to deliver 10%-12% return on capital and generate some $10 billion in annual cash flow.

Upstream Americas performance improving The second piece of encouraging news was that Shell's upstream Americas business -- its other main underperforming division -- finally swung to a profit of $550 million during the first quarter thanks primarily to higher natural gas prices in North America and the acquisition of South American liquefied natural gas assets from Repsol.

The division had been a consistent loss maker due to poor drilling results that resulted in substantial writedowns in the value of its shale assets. To improve the division's returns, Shell plans to reduce upstream Americas spending by 20% this year and has already announced the sales of various shale assets, including acreage in Texas' Eagle Ford and Kansas' Mississippi Lime play.

Going forward, Shell will continue to focus its upstream Americas efforts on its most promising opportunities, mainly in the Gulf of Mexico and West Texas' Permian Basin, which should help gradually improve the unit's returns.

Cash flow up sharplyLastly, and most important, Shell's cash flow is finally outpacing spending. First-quarter operating cash flow came in at $14 billion, up 21% year over year and the highest level in quite some time, compared to capital spending of $10.7 billion for the three-month period. This helped the company generate $6 billion in free cash flow, which was easily enough to cover dividends.

Generating stronger cash flow will remain key for the company. In previous years, Shell struggled to fund its capital expenditures through operating cash flow as spending ballooned to record levels, causing investors to question the sustainability of its dividend payments. But with major high-margin projects slated to start over the next few years, and with spending expected to decline considerably, cash flow looks set to improve big time.

If Shell can continue to deliver its high-margin projects on time and on budget, and assuming Brent crude prices hold steady above $100 per barrel, the company's target of $45 billion in annual operating cash flow over the next few years may be achievable. Hitting that goal should enable the company to grow its dividend at a modest pace in coming years.

Investor takeaway Despite a plunge in its first-quarter earnings, Shell's efforts to restructure its underperforming downstream and upstream Americas businesses are progressing slowly but surely, while cash flow looks set to improve sharply as new high-margin projects come online over the next couple of years. Though Shell still has a lot of work to do in improving its returns on capital, the company certainly appears to be on the right track.

Author

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.